Getting your finances in order
Take a moment and think about your current financial practices. Do you mix insurance with investment? Do you rely only on your employer provided health cover? Do you invest too conservatively even for your long-term financial goals?
It is important to assess your current financial practices and think whether these are right. It is only then you will be able to address any issues that are there. We find a common set of practices among investors, which are not prudent to follow. One misstep alone may not harm us, but taken together over time, these can cost us huge in the long run. Ahead of the new financial year, we offer a look at these common practices, and ways to stop them. Read on.
Considering insurance as a form of investment
Most of us look at insurance as a form of investment. We buy life insurance policies in an anticipation to get something in return or at least the premium that we have paid. Which is why, majority of investors, consider buying term plans with ' return of premium' feature than 'pure' term plans, which do not provide anything in return in
case of survival of a policyholder at the end of the term.
However, it is not a good practice to mix insurance with investment. The core purpose
of insurance is to provide protection. Buying a pure term plan for protection purpose
and investing separately for goals helps. Let's understand this with an example:
For a 30-year old healthy male, for a sum assured of Rs. 25 lakh and a term of 25 years, approximate premium charged in a 'pure' term plan is Rs 4,300 p.a., whereas for a term plan with 'return of premium' feature, it is around Rs 11,300 p.a. This means, the actual premium for covering the risk of death is only Rs 4,300 p.a., and in a 'return of premium' term plan, the remaining Rs7,000 p.a. is utilized to invest and recover the total premiums paid of Rs2,82,500 (11,300 x 25 years). So, if you look at the return generated from this, it is around 3.50% p.a. only (For an investment of Rs7,000 p.a., to grow at Rs 2,82,500, return required is only 3.50% p.a.). Instead, if you take a pure term plan for Rs 4,300 p.a. and the balance Rs 7,000 p.a. invest into, say, equity mutual funds, you will be able to accumulate 10.45 lakh, assuming a return of 12% p.a.
Relying only on employer provided health cover
Most of the salaried people rely only on the group health insurance cover provided by
their employers, and do not take the separate cover. For instance, last year, the Insurance Regulatory and Development Authority (IRDA) had estimated that in India,
only 2.73 crore people had an individual cover for themselves.
Relying only on group health insurance cover of your employer is not advisable for
the following reasons: Of late, some employers have asked employees to bear a part of the premium; some have started covering only employee and immediate family, not parents. Further, when one shifts job, there is no cover during the break period. A new employer may or may not provide a health cover. An existing employer could also
withdraw the cover anytime.
Further, the amount of cover provided by your employer may not be sufficient. Last but not the least, when one relies only on the employer-provided cover, and decides to take a separate cover later i.e. closer to retirement, the premium is very high, one may have to undergo a medical examination and may not get the cover if he or she has any
critical disease. There is also a waiting period for pre-existing diseases to be covered. Hence, it is important to take a separate health cover, early in life, to avoid these circumstances.
There is another report 'Aarogya Bharat 2015' , released by NATHEALTH, which shows that 70% Indians don't have health insurance.
Remember, medical expenses can quickly wipe out savings and investments and thus
jeopardize our family's financial well-being. So, don't let health insurance take a backseat, procure it today and maintain it regularly to lead a hassle-free life.
Investing a lump sum in PPF towards the end of financial year for saving tax
This is another common practice among investors, to invest a lump sum amount in
public provident fund (PPF) account, towards the end of every financial year in order to save tax.
This is mainly because most of us are not aware of the minute details of how a PPF account works, and look at it as just another instrument for saving taxes or accumulating a corpus for future requirement. Instead of contributing at the last moment, if you try and contribute to your PPF account at the start of every financial
year, it can make a good difference to your accumulated corpus. Let's understand this with an example:
Say you invest 1 lakh p.a. into PPF for next 15 years. If this investment is made at the end of every financial year, you will be accumulating 28.23 lakh at the end of 15 years, assuming an average return of 8.5% p.a. But, if you invest at the start of every financial year, you will be able to accumulate 30.63 lakh at the same rate of return, giving you an additional amount of 2.40 lakh in the corpus.
Investing too conservatively for long-term goals
The habit of investing in post office (PO) schemes or traditional fixed deposits (Fds)
for long- term goals such as child's higher education and marriage is another common
practice among Indians. We can see , even today, grandparents gifting an FD of a
longer tenure in the name ofgrandchildren, for any future requirement.
While investing early on for children's goals is good, investing conservatively in debt instruments for such long-term goals will hardly beat the inflation. Further, the cost of education is skyrocketing; the returns generated by debt instruments would hardly keep the pace with rising cost. To add to it, the returns generated from debt instruments are taxable and hence, the net return generated is much lower than the growth assets such as equity.
Say for example, you invest Rs 5 lakh today into an FD for 10 years to fund your child's graduation after 10 years. You expect the cost of graduation to be Rs 5 lakh (in today's value). With the cost of education growing at a rapid pace, the cost can grow up to Rs 12.97 lakh after 10 years (assuming an inflation rate of 10% p.a.).
However, the FD can grow to Rs 11.84 lakh after 10 years (assuming an interest rate of
9% p.a.). But after tax, the FD will fetch only Rs 9.72 lakh (assuming a tax of 30.9%) as against the future cost of graduation of Rs 12.97 lakh.
Thus, for long-term goals, it is always advisable to invest into growth assets such as equity mutual funds, which will protect you not only against inflation, but also taxes. In fact, the amount required to invest also comes down due to these benefits. In the above example, the lump sum investment required in an FD was Rs 5 lakh, but if you invest in equity mutual funds, it will be just Rs 4.18 lakh to accumulate the future value of Rs 12.97 lakh (assuming a return of 12% p.a.). And to accumulate the future value of Rs 12.97 lakh (post tax), the lumpsum investment required in an FD would be 6.98 lakh as against Rs 4.18 lakh in equity instruments.
Opting for dividend schemes of mutual funds for long-term goals
Some individuals do invest in growth assets, such as equity mutual funds, for their long term goals. However, they choose dividend opt ion instead of growth option. They see dividend as a regular income (though funds do not declare dividend on a regular basis), in addition to the appreciation expected from the fund.
However, one should note that, whenever a mutual fund declares dividend, the NAV of a fund comes down to the extent of the dividend declared. For example, if the NAV of a fund is Rs 35 and the fund declares a dividend of Rs 5 per unit, the NAV of a fund comes down to Rs 30 post dividend. So, when you opt for the dividend option, you actually withdraw the part of the capital appreciated, in the form of dividend. It is therefore better to opt for growth option for long-term financial goals, as one generally does not require income in between in the form of dividends, plus the capital keeps getting appreciated over the long run.
Over-diversifying stock and MF Holdings
It is a well established fact that diversification helps reduce the overall portfolio risk whilemaintaining the expected level of returns. However, if you overdo, it could actually work against you. Many investors don't realize how the portfolio becomes too complex to understand with over - diversification. Further, the tracking and monitoring
becomes difficult.
We have seen investors holding as many as 40 mutual funds (MFs) and 100 stocks in a
portfolio. There is a misplaced belief that with every additional stock / mutual fund in the portfolio, the overall risk gets reduced to that extent . However, this is not true. According to the modern portfolio theory, you would come very close to achieving
optimal diversity after adding about the 20th stock to your portfolio. In Edwin J. Elton and Martin J. Gruber's book "Modern Portfolio Theory and Investment Analysis", they
conclude that the average standard deviation (risk) of a portfolio of one stock was 49.2%, while increasing the number of stocks in the average well - balanced portfolio could reduce the portfolio's standard deviation to a maximum of 19.2% (this number represents market risk). However, they also found that with a portfolio of 20 stocks the risk was reduced to about 20%. Therefore, the additional stocks from 20 to 1,000 only reduced the portfolio's risk by about 0.8%, while the first 20 stocks reduced the portfolio's risk by 29.2% (49.2%-20%).
While in case of mutual funds, 7-8 funds - across categories of equity, debt and gold- make a good number. It does not make sense to pile up 30-40 schemes, since mutual funds itself offer you the inherent benefit of diversification. Further, with every addition, there could be a chance of duplication, without adding any value to the portfolio. For example, all diversified equity funds have a basket of stocks, with the holdings spread across companies and sectors. If you choose 10 to 15 diversified equity funds, each having at least 50-60 stocks in their kitty, you could end up paying more money for funds which are picking the same set of stocks.
Buying MFs with lower NAV thinking they are cheap/give better return
This is another common practice / misconception among MF investors. The general theory behind this misconception is that a lower NAV fund can grow faster than a higher NAV fund. However, this is not the case. Let's understand this with an
example:
There are two similar MF schemes, Scheme 'A' with NAV of 15 and Scheme 'B' with
NAV 150. Let's assume you invest 15,000 into both. You will get 1,000 units of Scheme 'A' and 100 units of Scheme 'B'. If the market goes up by 20%, then the NAV of Scheme 'A' goes up to 18, whereas NAV of Scheme 'B' goes up to 180. The value of Scheme 'A' would be 18,000 (1,000 units x 18) and the value of Scheme 'B' would be 18,000 (100 units x 180). Hence, it does not matter whether the NAV is lower or higher. Instead of looking at the NAV of a fund, it is important to look at other various factors such as its historical performance and track record, risk-adjusted rate of return, expense ratio, etc.
Taking personal loan instead of leveraging existing assets
Usually, in case of financial emergency, people turn to personal loans. However, there
are certain alternatives which may come in handy in hard time s . These include
leveraging your existing assets and investments such property, gold, shares, insurance policies, fixed deposits, etc. There are loans available against these assets and the interest rates on these are generally lower (13-15% p.a.) when compared to personal loans (16 - 30% p.a.).
One may also go in for an overdraft facility offered by various banks against savings
or current accounts in case of an emergency.
Leaving assets uninsured
Not only life and health insurance, general insurance penetration is also low in India,
e.g. home insurance. Most Indians do not bother to take home insurance, even though
the rates are low. It is important to get your assets such as home, home contents, etc.
accurately appraised and take a cover to fit your collection. It costs just about 15 a day to insure your most valuable asset - your home - and its contents (Assuming you take a cover of 50 lakh). If you al ready have insurance, consider whether you need an update.
Summing up
The way we build our routines today define the future course of our financial position. It is therefore important to follow good personal finance practices in order to secure our future. Managing personal finances is not difficult, it is all in our control to be disciplined with our investments, and lead a healthy financial life.
Happy Investing
Take a moment and think about your current financial practices. Do you mix insurance with investment? Do you rely only on your employer provided health cover? Do you invest too conservatively even for your long-term financial goals?
It is important to assess your current financial practices and think whether these are right. It is only then you will be able to address any issues that are there. We find a common set of practices among investors, which are not prudent to follow. One misstep alone may not harm us, but taken together over time, these can cost us huge in the long run. Ahead of the new financial year, we offer a look at these common practices, and ways to stop them. Read on.
Considering insurance as a form of investment
Most of us look at insurance as a form of investment. We buy life insurance policies in an anticipation to get something in return or at least the premium that we have paid. Which is why, majority of investors, consider buying term plans with ' return of premium' feature than 'pure' term plans, which do not provide anything in return in
case of survival of a policyholder at the end of the term.
However, it is not a good practice to mix insurance with investment. The core purpose
of insurance is to provide protection. Buying a pure term plan for protection purpose
and investing separately for goals helps. Let's understand this with an example:
For a 30-year old healthy male, for a sum assured of Rs. 25 lakh and a term of 25 years, approximate premium charged in a 'pure' term plan is Rs 4,300 p.a., whereas for a term plan with 'return of premium' feature, it is around Rs 11,300 p.a. This means, the actual premium for covering the risk of death is only Rs 4,300 p.a., and in a 'return of premium' term plan, the remaining Rs7,000 p.a. is utilized to invest and recover the total premiums paid of Rs2,82,500 (11,300 x 25 years). So, if you look at the return generated from this, it is around 3.50% p.a. only (For an investment of Rs7,000 p.a., to grow at Rs 2,82,500, return required is only 3.50% p.a.). Instead, if you take a pure term plan for Rs 4,300 p.a. and the balance Rs 7,000 p.a. invest into, say, equity mutual funds, you will be able to accumulate 10.45 lakh, assuming a return of 12% p.a.
Relying only on employer provided health cover
Most of the salaried people rely only on the group health insurance cover provided by
their employers, and do not take the separate cover. For instance, last year, the Insurance Regulatory and Development Authority (IRDA) had estimated that in India,
only 2.73 crore people had an individual cover for themselves.
Relying only on group health insurance cover of your employer is not advisable for
the following reasons: Of late, some employers have asked employees to bear a part of the premium; some have started covering only employee and immediate family, not parents. Further, when one shifts job, there is no cover during the break period. A new employer may or may not provide a health cover. An existing employer could also
withdraw the cover anytime.
Further, the amount of cover provided by your employer may not be sufficient. Last but not the least, when one relies only on the employer-provided cover, and decides to take a separate cover later i.e. closer to retirement, the premium is very high, one may have to undergo a medical examination and may not get the cover if he or she has any
critical disease. There is also a waiting period for pre-existing diseases to be covered. Hence, it is important to take a separate health cover, early in life, to avoid these circumstances.
There is another report 'Aarogya Bharat 2015' , released by NATHEALTH, which shows that 70% Indians don't have health insurance.
Remember, medical expenses can quickly wipe out savings and investments and thus
jeopardize our family's financial well-being. So, don't let health insurance take a backseat, procure it today and maintain it regularly to lead a hassle-free life.
Investing a lump sum in PPF towards the end of financial year for saving tax
This is another common practice among investors, to invest a lump sum amount in
public provident fund (PPF) account, towards the end of every financial year in order to save tax.
This is mainly because most of us are not aware of the minute details of how a PPF account works, and look at it as just another instrument for saving taxes or accumulating a corpus for future requirement. Instead of contributing at the last moment, if you try and contribute to your PPF account at the start of every financial
year, it can make a good difference to your accumulated corpus. Let's understand this with an example:
Say you invest 1 lakh p.a. into PPF for next 15 years. If this investment is made at the end of every financial year, you will be accumulating 28.23 lakh at the end of 15 years, assuming an average return of 8.5% p.a. But, if you invest at the start of every financial year, you will be able to accumulate 30.63 lakh at the same rate of return, giving you an additional amount of 2.40 lakh in the corpus.
Investing too conservatively for long-term goals
The habit of investing in post office (PO) schemes or traditional fixed deposits (Fds)
for long- term goals such as child's higher education and marriage is another common
practice among Indians. We can see , even today, grandparents gifting an FD of a
longer tenure in the name ofgrandchildren, for any future requirement.
While investing early on for children's goals is good, investing conservatively in debt instruments for such long-term goals will hardly beat the inflation. Further, the cost of education is skyrocketing; the returns generated by debt instruments would hardly keep the pace with rising cost. To add to it, the returns generated from debt instruments are taxable and hence, the net return generated is much lower than the growth assets such as equity.
Say for example, you invest Rs 5 lakh today into an FD for 10 years to fund your child's graduation after 10 years. You expect the cost of graduation to be Rs 5 lakh (in today's value). With the cost of education growing at a rapid pace, the cost can grow up to Rs 12.97 lakh after 10 years (assuming an inflation rate of 10% p.a.).
However, the FD can grow to Rs 11.84 lakh after 10 years (assuming an interest rate of
9% p.a.). But after tax, the FD will fetch only Rs 9.72 lakh (assuming a tax of 30.9%) as against the future cost of graduation of Rs 12.97 lakh.
Thus, for long-term goals, it is always advisable to invest into growth assets such as equity mutual funds, which will protect you not only against inflation, but also taxes. In fact, the amount required to invest also comes down due to these benefits. In the above example, the lump sum investment required in an FD was Rs 5 lakh, but if you invest in equity mutual funds, it will be just Rs 4.18 lakh to accumulate the future value of Rs 12.97 lakh (assuming a return of 12% p.a.). And to accumulate the future value of Rs 12.97 lakh (post tax), the lumpsum investment required in an FD would be 6.98 lakh as against Rs 4.18 lakh in equity instruments.
Opting for dividend schemes of mutual funds for long-term goals
Some individuals do invest in growth assets, such as equity mutual funds, for their long term goals. However, they choose dividend opt ion instead of growth option. They see dividend as a regular income (though funds do not declare dividend on a regular basis), in addition to the appreciation expected from the fund.
However, one should note that, whenever a mutual fund declares dividend, the NAV of a fund comes down to the extent of the dividend declared. For example, if the NAV of a fund is Rs 35 and the fund declares a dividend of Rs 5 per unit, the NAV of a fund comes down to Rs 30 post dividend. So, when you opt for the dividend option, you actually withdraw the part of the capital appreciated, in the form of dividend. It is therefore better to opt for growth option for long-term financial goals, as one generally does not require income in between in the form of dividends, plus the capital keeps getting appreciated over the long run.
Over-diversifying stock and MF Holdings
It is a well established fact that diversification helps reduce the overall portfolio risk whilemaintaining the expected level of returns. However, if you overdo, it could actually work against you. Many investors don't realize how the portfolio becomes too complex to understand with over - diversification. Further, the tracking and monitoring
becomes difficult.
We have seen investors holding as many as 40 mutual funds (MFs) and 100 stocks in a
portfolio. There is a misplaced belief that with every additional stock / mutual fund in the portfolio, the overall risk gets reduced to that extent . However, this is not true. According to the modern portfolio theory, you would come very close to achieving
optimal diversity after adding about the 20th stock to your portfolio. In Edwin J. Elton and Martin J. Gruber's book "Modern Portfolio Theory and Investment Analysis", they
conclude that the average standard deviation (risk) of a portfolio of one stock was 49.2%, while increasing the number of stocks in the average well - balanced portfolio could reduce the portfolio's standard deviation to a maximum of 19.2% (this number represents market risk). However, they also found that with a portfolio of 20 stocks the risk was reduced to about 20%. Therefore, the additional stocks from 20 to 1,000 only reduced the portfolio's risk by about 0.8%, while the first 20 stocks reduced the portfolio's risk by 29.2% (49.2%-20%).
While in case of mutual funds, 7-8 funds - across categories of equity, debt and gold- make a good number. It does not make sense to pile up 30-40 schemes, since mutual funds itself offer you the inherent benefit of diversification. Further, with every addition, there could be a chance of duplication, without adding any value to the portfolio. For example, all diversified equity funds have a basket of stocks, with the holdings spread across companies and sectors. If you choose 10 to 15 diversified equity funds, each having at least 50-60 stocks in their kitty, you could end up paying more money for funds which are picking the same set of stocks.
Buying MFs with lower NAV thinking they are cheap/give better return
This is another common practice / misconception among MF investors. The general theory behind this misconception is that a lower NAV fund can grow faster than a higher NAV fund. However, this is not the case. Let's understand this with an
example:
There are two similar MF schemes, Scheme 'A' with NAV of 15 and Scheme 'B' with
NAV 150. Let's assume you invest 15,000 into both. You will get 1,000 units of Scheme 'A' and 100 units of Scheme 'B'. If the market goes up by 20%, then the NAV of Scheme 'A' goes up to 18, whereas NAV of Scheme 'B' goes up to 180. The value of Scheme 'A' would be 18,000 (1,000 units x 18) and the value of Scheme 'B' would be 18,000 (100 units x 180). Hence, it does not matter whether the NAV is lower or higher. Instead of looking at the NAV of a fund, it is important to look at other various factors such as its historical performance and track record, risk-adjusted rate of return, expense ratio, etc.
Taking personal loan instead of leveraging existing assets
Usually, in case of financial emergency, people turn to personal loans. However, there
are certain alternatives which may come in handy in hard time s . These include
leveraging your existing assets and investments such property, gold, shares, insurance policies, fixed deposits, etc. There are loans available against these assets and the interest rates on these are generally lower (13-15% p.a.) when compared to personal loans (16 - 30% p.a.).
One may also go in for an overdraft facility offered by various banks against savings
or current accounts in case of an emergency.
Leaving assets uninsured
Not only life and health insurance, general insurance penetration is also low in India,
e.g. home insurance. Most Indians do not bother to take home insurance, even though
the rates are low. It is important to get your assets such as home, home contents, etc.
accurately appraised and take a cover to fit your collection. It costs just about 15 a day to insure your most valuable asset - your home - and its contents (Assuming you take a cover of 50 lakh). If you al ready have insurance, consider whether you need an update.
Summing up
The way we build our routines today define the future course of our financial position. It is therefore important to follow good personal finance practices in order to secure our future. Managing personal finances is not difficult, it is all in our control to be disciplined with our investments, and lead a healthy financial life.
Happy Investing
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